We have used a panel database of banks from 27 EU countries to explore how loan loss provisions respond to the business cycle. We have applied the two step system GMM Blundell and Bond (1998) estimator, to control for potential endogeneity and unobserved heterogeneity of the explanatory variables. This paper documents a large cross-country and cross-bank variation in the relationship between loan loss provisions and the business cycle and explores country specific (institutional and regulatory) and bank specific features that explain this diversity.
The factors explaining differences in LLP sensitivity to the business cycle across EU banks and countries are many and varied. Our results indicate that LLP in large, publicly traded and commercial banks are more procyclical than in other subsamples.
Better investor protection and more restrictive bank capital regulations reduce the procyclicality of LLP. What is more, moral hazard resulting from deposit insurance results in more procyclicality of LLP. We do not find support for the view that better quality of market monitoring mitigates the procyclical behavior of banks.
This study is relevant to the current policy debate on the role of size in procyclical behavior of banks. In particular we provide new evidence that large systemically important banks should be regulated more restrictively, as they have a tendency to take on more risks, as is evident in our results for banks reporting consolidated statements. This gives support to the Basel Committee
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capital standards for systemically important financial institutions (SIFIs), included in the Basel III framework.
Additionally, as our results suggest the importance of bank regulations in limiting the risk taking activity by banks, and therefore limiting procyclicality in banking, we provide strong support for contemporary attempts to make banking sector better regulated. Our results are also important to current macroprudential policy recommendations, promoting the forward looking provisioning (by the Basel Committee and other international institutions, such as the International Monetary Fund). In particular, we find support for the view that more income smoothing and prudent risk management leads to less procyclicality of LLP.
Acknowledgements
We gratefully acknowledge the financial support provided by Polish National Scientific Centre (NCN), No. of decision DEC-2012/05/D/HS4/01356. This paper’s findings, interpretations, an conclusions are entirely those of the authors and do not necessarily represent the views of the University of Warsaw or other institutions at which the authors are affiliated. We thank participants in the “Panel Data Modelling Conference. Theory and practice” held at Warsaw School of Economics, in the Scientific seminar held at National Bank of Poland and in the International Conference on Management, Banking and Finance in Warsaw at University of Warsaw, for their helpful comments and suggestions. We also thank Patrycja Chodnicka for wonderful research assistance.
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